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Date : 16/02/2023

Commonwealth Bank of Australia

ASX :

CBA

Market Cap : $171.37 Billion

Dividend Per Share : $4.20

Dividend Yield : 4.13 %

Hold

52 Week Range : $86.98 - $111.43

Share Price : $101.50

CBA delivers record profits and dividends. However, outlook weighs on share price. We recommend a 'Hold.'

Company Analysis

Commonwealth Bank of Australia (ASX: CBA) is highly intertwined with the Australian economy, and its half-year result and market reaction epitomised it. CBA delivered record profits and hiked its dividends by 20%; however, the softening economic outlook indicated that CBA’s string of good results might be coming to an end – resulting in shares dropping significantly (~6%). CBA also sets the tone for the banking industry, resulting in all the Big 4 shedding losses.

The overarching story of CBA’s result is that profits increased as higher interest rates meant that Net Interest Margin (NIM) saw a further increase. The dark side of higher interest rates is that Australians with mortgages and other loans are now starting to feel tighter, leading CBA to increase credit provisions.

The highlights of the most important metrics from the results are as below. These numbers were broadly in line with expectations:

  • Statutory NPAT was $5,216 million, up 10%.
  • Cash NPAT of $5,153 million was 9% higher, reflecting strong operational performance, a rising rate environment and higher loan loss provisioning.
  • Operating income was $13,593 million, up 12%, driven by volume growth in our core products and a recovery in net interest margin, partly offset by a decrease in other operating income.
  • Net interest margin was 2.10%, up by 18 basis points, mainly driven by higher earnings on deposits, replicated products and equity hedges in a rising rate environment, partly offset by increased competition.
  • Operating expenses were $5,773 million, up 5%, driven by wage and supplier inflation, higher information technology costs and remediation, partly offset by productivity initiatives.
  • Loan impairment expense increased by $586 million to $511 million, reflecting ongoing inflationary pressures, rising interest rates, supply chain disruptions and a decline in house prices.
  • Deposit funding of 75%, as the Bank continued to satisfy a significant portion of its funding requirements from retail, business, and institutional customer deposits.
  • Common Equity Tier 1 (CET1) capital ratio of 11.4% (Level 2, APRA). On the 1st of January 2023, this increased to 12.1% under APRA’s revised capital framework.
  • Interim dividend of $2.10 per share, fully franked. This represents a payout ratio of 69% and an increase of $0.35 on pcp. CBA goes ex-dividend on the 22nd of February, with the dividend being paid out on the 30th of March.

Where is Net Interest Margin Headed?

Net Interest Margin is the difference between how much interest a bank pays on deposits and how much interest it gains on its loans. Therefore, it is the single most important metric that determines profitability.

CBA’s biggest business is mortgages, which account for about 70% of its loan book. It is heavily leveraged in the housing market, which is undergoing a cyclical downturn with rising interest rates. This means new loans will be hard to come by, and current loans have to be safeguarded by increasing provisions for credit impairment. As a result, the total impairment provisions increased by $194 million to $5.5 billion in the prior half.

Competition for home loans has reached its height, leading to the banks even looking at acquisitions to boost their mortgage book (For example, ANZ’s deal for Suncorp). This competition, coupled with low demand for home loans on the back of high-interest rates, means that CBA’s mortgage book growth has peaked.

On the flip side, customer deposits are increasing by the day due to rising interest rates. Competition is also increasing significantly in this segment, forcing banks to pass on the increased rates to clients. Deposit pricing has come under political scrutiny in the form of an ACCC pricing inquiry, as banks delay passing rate rises to savers to boost profits. CBA has been guilty of not passing on the increased rates quickly enough so far; however, this will change going forward purely due to the competition that is present.

While the downward pressure from higher interest on deposits and slowing mortgage growth may not be felt right away, it does show signs that the net interest margin may have peaked for CBA. This has been the biggest concern in the market following the result – leading to a 6% share price drop.

Loan Provisions are Increasing

While credit quality remains strong, loan arrears are at record lows. The results show that high-interest rates are expected to squeeze some customers.

Loan impairment expense was $511 million, an increase of $586 million, reflecting ongoing inflationary pressures, supply chain disruptions, rising interest rates and a decline in house prices. The loan loss rate increased 13 basis points to 11 basis points. Total provisions were lifted to $5.5 billion. Compared to pre-pandemic, during ultra-low interest rates, we can clearly see just how much the scenario has changed from the ideal operating environment.

Does this pose a danger? Not quite. While the increasing loan provisions have their say on profits, CBA has already been proactive on this front.

Higher rates are yet to hit one-third of CBA’s mortgage customers: $82 billion of cheaply priced, fixed-rate loans are set to roll off to higher variable rates by the end of this calendar year, with the same number rolling off sometime next year. CBA said 34% of its customers were more than two years in advance with repayments, and 23% are paying on time.

This shows that there is no immediate threat. Despite today’s numbers, the job market remains extremely robust and it will also have its say regarding mortgage repayments – cushioning the impact of interest rate hikes.

What’s Priced in?

All this being said, we can expect CBA’s growth and profit increases to slow in the medium term. CBA did not provide guidance, but for FY23, markets have priced in a 12% revenue growth for the full year. However, on the profit front, consensus expects margins to fall as CBA’s costs rise due to its digitisation push, coupled with NIM having peaked. This has resulted in single-digit EPS growth being priced in.

But we’re all here for its dividends. The EPS should support a similar payout ratio of around 70-75%, which is well within CBA’s dividend payout policy. This should put the final dividend in the $2.23 range.

Our earlier coverage of CBA can be viewed by clicking here.

Recommendation

CBA delivered a 1H23 result that was broadly in line with expectations. Profits and dividends increased considerably; however, the gloomy outlook due to the economic slowdown is looming large. The rising interest rates will result in slower mortgage book growth and higher rates on customer deposits, which are increasing. Ultimately, we expect this to impact Net Interest Margins. CommBank also increased credit provisions, and the markets moved yesterday to price all this in. A single-digit EPS growth is now priced in, and at the usual ~70% payout ratio, we can expect CBA’s final dividends to be around $2.23 for the full year FY23. This translates into a forward dividend yield of over 4% fully franked. We recommend investors ‘Hold‘ positions and consider topping up at around the $93 range (green line in the below chart), which is near the pre-pandemic high.

 

 

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